First Quarter 2008 Fixed Income Market Review
April 17, 2008
Author(s):
Against a backdrop of troubled world markets and deteriorating economic conditions, the Federal Reserve lowered its target for the federal funds rate by 75 basis points to 3.50% at its inter-meeting on January 22. This emergency rate cut was seen as an action to stabilize the wide-spread panic in the financial markets. This rate cut was followed by two more rate cuts totaling 125 basis points from 3.50% to 2.25% (50 basis points on January 30, and 75 basis point on March 18). In a statement following its last meeting on March 18, the Federal Reserve Open Markets Committee ("FOMC") acknowledged that the outlook for U.S. economic growth has further weakened and that “strains in financial markets” have increased. The FOMC also repeated its prior cautionary inflation comments, concluding that “inflation has been elevated and some indicators of inflation expectations have risen” and must be monitored closely. Treasuries outperformed most other fixed income sectors in the first quarter of 2008 as a result of the continuation of “flight to quality” trades, as investors sought refuge in this high quality investment. The yield curve continued its steepening trend with the spread between the 10 year Treasury and the 2 year Treasury almost doubling to 182 basis points as of March 31, 2008 from 97 basis points as of December 31, 2007 .
Fixed income market returns ranged from negative 12.46%, posted by Home Equity Asset-Backed Securities, to positive 5.76%, posted by the 10 year Treasury. Higher grade credits and longer maturity Treasuries exhibited the best absolute returns. The broadly followed Lehman Aggregate Index had a total return of 2.17% for the first quarter of 2008. Its yield decreased from 4.90% on December 31, 2007 to 4.51% on March 31, 2008. The 2 year Treasury Bellwether Index had a total return of 3.36%, whereas the 10 year Index had a total return of 5.75%, for a difference of 239 basis points for the quarter. The 30 year Treasury Index, with a total return of 3.66%, also underperformed the 10 year Index. The yield of the 2 year Treasury Index decreased by 145 basis points from 3.07% to 1.62%, the yield on the 10 year Index decreased by 60 basis points from 4.03% to 3.43% and the yield on the 30 year Index decreased by only 15 basis points from 4.46% to 4.31%. Contributing to the higher performance for the 10 year Treasury versus the 2 year Treasury was its much higher duration of 8.58 years versus 1.96 years for the 2 year Treasury. U.S. credits provided a total return of 0.43% for the first quarter. The “credit spread” differential widened more for triple-B rated securities than the higher rated securities during the quarter as the triple-A sector had a total return of 2.77%, which was 170 basis points better than the –1.07% return provided by triple-B sector. The duration of the MBS sector decreased from 2.99 years as of December 31 to 2.91 years as of March 31, which contributed to a slight decrease in the duration of the Aggregate Index from 4.41 years to 4.38 years.
The tax-exempt municipal bond market also experienced mixed returns in the first quarter with returns ranging from negative 4.14%, posted by 22+ year municipals, to positive 2.23%, posted by 3 year municipals. Tax-exempt municipals underperformed Treasuries across all maturities as evidenced by the fact that the 3 year municipals, which were the best performing sector of the municipal bond market, had a total return of 2.23%, whereas the 3 year Treasuries had a return of 3.81% (a difference of 158 basis points); 10 year municipals had a total return of only 0.31%, whereas the 10 year Treasuries had a return of 5.75% (a difference of 544 basis points).
Past performance is no guarantee of future results. Indices are not available for direct investment. This material has been prepared using sources of information generally believed to be reliable. No representations can be made as to its accuracy. Opinions represented are subject to change and should not be considered investment advice nor an offer of securities.
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